Loans: Prepayment Penalty Upheld
The Colorado Court of Appeals ruled that a large loan prepayment penalty was enforceable and not unconscionable in the case of Planned Pethood Plus v. Keycorp, Inc., 2010 WL 185414 (Colo. App.). Pethood is a veterinary clinic owned by two veterinarians. It obtained a commercial loan of $389,000 from Keybank at a fixed interest rate of 8.3 percent for a term of 10 years. The promissory note contained a clause, prominently displayed on the first page, allowing Pethood to prepay the loan in whole or part by paying the lender a penalty equal to (1) prepayment amount, (2) times the number of years remaining on the loan, (3) times 1-1/4 percent. After 16 months, Pethood prepaid the loan together with a prepayment penalty of $40,500. This represented a penalty of 10.7 percent of the principal balance. Pethood then began this suit. The trial court entered judgment in favor of Keybank, and Pethood appealed.
Not Liquidated Damages
Whether a prepayment penalty can be upheld
as a form of liquidated damages was an issue
of first impression in Colorado. The general
rule is that when a breach of a loan contract
occurs, a liquidated damages provision must
be reasonable in light of the anticipated or
actual loss caused by the breach. A liquidated
damages provision must not be unreasonably
large for the expected loss from a breach of
contract. Said the court, “Even if Pethood is
correct that the prepayment is unreasonable,
it is not an unenforceable penalty under the
law of liquidated damages because there was
no breach of contract. Pethood exercised its
right to prepay the loan, thereby triggering the
prepayment penalty."
Where a borrower exercises an alternative
form of performance by invoking a
prepayment privilege, the law of liquidated
damages is inapplicable. Prepayment penalties
are generally considered valid provisions
for alternative performance rather than
penalties or liquidated damages. Said the
court, “Prepayment provisions simply grant
borrowers the right to prepay the loan in
exchange for paying the lender a fee.…
Because the borrower retains control over
the manner of performance, prepayment
with a penalty is an alternative manner of
performance, not liquidated damages."
Unconscionability
Pethood then argued that the prepayment
penalty is nevertheless void on equitable
grounds because it is unconscionable. The
court disagreed. The court said that a penalty
might be so large as to render its enforcement
unconscionable and in such case a court has
the equitable power to refuse to enforce it.
However, the prepayment amount here was
not unconscionable. In addition to being
relatively small, the penalty clause was
prominently displayed on the first page of the
note, which the borrowers signed. In addition,
the borrowers had previously negotiated
for other commercial loans, two of which
contained prepayment penalty clauses. The
appellate court confirmed the ruling of the
trial court.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Alvin Arnold is the editor of the Monitor. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
Somerset CPAs,
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
info@somersetcpas.com
.jpg)